By: Thomas Fekete EMEA Head of Strategy and Products for Sustainable Investing at BlackRock
For decades, investors have been choosing an index approach to actively pursue the goals that matter to them most. Today, as more and more investors are recognising that sustainability-related considerations, such as climate change, can impact longterm returns, indexing is increasingly helping them transition to portfolios that better reflect their sustainable and financial goals. This shift is already visible in the accelerated growth of assets under management in sustainable index strategies. At Blackrock, we believe the growth of sustainable indexing is just getting started. However, despite this growth, sustainable investing remains a nascent category. As a result, questions about the validity of sustainable indexing may be born out of an incomplete understanding or outdated perception of index investing more broadly.
Many misconceptions stem from the notion that ‘sustainable investing is different’, which infers that indexing cannot or should not work in this investment category in the way that it does across traditional equity and fixed income strategies. We would agree that this relatively new area of investing requires further education and is in its infancy in many regards, but would also argue that indexing is particularly valuable in the context of creating a common language for sustainable investing. Indexing is helping to transform a nebulous category, full of acronyms and jargon, by aggregating, standardising, and bringing transparency to sustainability data and investment methodologies. This transparency creates cost-effective, actionable exposures that make sustainable portfolio construction and management far more efficient. In our report Sustainable Mythbusting, we debunk the common myths associated with sustainable index investing and provide the facts to help investors build more sustainable portfolios.
Myth 1: Sustainable investing lacks a common definition; there are no clear standards for building a sustainable portfolio
Sustainable investing is the practice of understanding and incorporating ESG factors into investment analysis and decision making. Historically, the focus has been on avoiding exposure to companies or sectors that pose certain risks or violate commonly-held values. However, investors are increasingly seeking to also advance their ESG objectives, or meet defined, relatable targets, such as a carbon footprint reduction across asset classes. While there is growing consensus on the importance of sustainable investing terminology, definitions and interpretations of this area of investing continue to vary across markets and stakeholders. This lack of common language is now sharply in focus for regulators across Europe and within the broader ESG ecosystem, including ESG data and index providers, stock exchanges, public companies and auditors. The push towards the robust standard-setting strongly encouraged by BlackRock will help to eliminate the perceived complexity of this field, counter the perception of “greenwashing”, and accelerate the sustainable finance transition.
Myth 2: Sustainable investing is too nuanced for index investing and requires active management to express investor values and preferences regarding environmental, social and governance (ESG) factors
Index investing enables investors to implement their sustainability preferences explicitly and consistently across exposures. Index investing is often conflated with a perceived dormancy or lack of flexibility that does not truly reflect the wide variety of ways that investors use ETFs and index funds to take control of their investment outcomes. Index investors are active investors and this extends to sustainable investing, where they are able to use index investing tools to actively reflect their sustainability goals.
Myth 3: Index fund managers lack the stewardship tools to drive change
Index fund managers deploying active investment stewardship can drive longterm change. Index fund managers take a long-term view, amplifying the impact of company engagements. Those who are sustainability-minded, like BlackRock, exercise influence with companies through engagements on ESG topics and they stay the course to see change happen. This is the value of patient capital.
Myth 4: Sustainable indexing works for equities but not for fixed income exposures, and fixed income ESG data will continue to lag behind equities
Sustainability preferences can be applied across a range of fixed income exposures, and the drivers of ESG demand in fixed income are similar to those for other asset classes. Indexing can be the starting point for a sustainable fixed income investment solution, and considerations such as sustainable impact and risk-return profile compared to non-sustainable equivalent products resonate particularly well in fixed income.
Myth 5: Sustainability comes at a premium
Indexing is bringing access to sustainable investing at a fraction of the cost. A few decades ago, investors had limited choice in how to access certain exposures: they could either pick securities themselves or pay a premium for actively managed mutual funds, many of which had inconsistent track records. However, the proliferation of ETFs and index funds lowered the cost of access for all investors, while providing transparency and precision. We believe indexing will do for sustainable investing what it did for traditional stock and bond investing. Until recently, sustainable investment strategies were only available through higher-fee actively managed funds or highly customised mandates that required in-house ESG specialisation. Sustainable indices are helping drive down the total costs of investing sustainably while broadening the variety of available exposures.
Myth 6: You have to sacrifice performance when using sustainable indexing
Early evidence on ESG index performance strongly challenges the tired misconception that sustainable investing requires giving up financial returns for better ESG outcomes. We looked at traditional equity indices alongside ESG-screened, ESG-optimised and ESG best-in-class versions. Our findings are outlined in the chart below. Since 2012, annualised returns for sustainable indices have matched or exceeded the standard index in both developed and emerging markets, with comparable volatility. Research indicates that the phenomenon can be explained through better governance, lower regulatory risks and a tilt to companies with healthier balance sheets. The empirical data is clear and objective: there is no evidence that investing sustainably requires a performance sacrifice; the opposite appears to be true.
The rapid growth of sustainable investing, paired with the proliferation of definitions, data providers and regulations, has led to unfounded claims that indexing cannot work in this space and that active management is the only solution. We believe that it is the very nature of sustainable investing, with the push towards increased reporting and standardisation that makes indexing not only valuable but necessary to accelerate the sustainable finance transition and empower the construction of sustainable portfolios. Indexing can be a driver for change when its patient capital perspective and stewardship approach is fully appreciated. For these reasons, we believe that not only does sustainable indexing work but that it will become an increasingly indispensable component of investors’ portfolios.